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As the Federal Reserve’s moment of truth approaches, with many in world capital markets desperate for it to defer a decision to start raising interest rates from their current historic low levels, one group begs to differ. Anyone who is trying to guarantee an income in retirement is desperate for rates to rise.
The reason is simple, even if it follows the often counter-intuitive mathematics of bonds. Buying an income means buying bonds. The lower rates are, the more money you have to spend on bonds to generate any given income.
In the case of defined benefit pensions, which guarantee a particular level of income to their retirees in advance, this is a real problem. At all times, they have to balance both their assets — which are generally invested in equities and will go up with the stock market — and their liabilities, which will grow if bond yields fall.
Defined benefit pensions are in long-term decline, as increasing life expectancy has caused employers to balk at the prospect of guaranteeing incomes long into the future. But much money remains tied up in such plans — and falling interest rates have been disastrous for them.
According to Ryan ALM, a US consulting service for pension plans, US pension asset growth has underperformed liability growth since the end of 1999, when the dotcom boom came to an end, by about 160 per cent. At that point, with the stock market high, most big pension plans were in surplus — meaning their assets were comfortably above the projected cost of meeting their liabilities. Since then, they have sunk into deficits, a situation that has become critical with the low rates that followed the crisis in 2008.
The gap between assets and liabilities for companies in the US S&P 1500 index
The scale of the problem is vast. According to Mercer, one of the largest consultants to pension plans, the total pension deficits — the gap between assets and liabilities — for companies in the US S&P 1500 index was $378bn at the end of March. This represented an improvement. Corporate bond yields, used to price their liabilities, have risen this year as sentiment gains hold that the Federal Reserve will soon raise rates. In January, the deficits had totalled $653bn.
For the UK’s FTSE 350 companies the picture is only slightly healthier. Mercer puts their deficits at £88bn in late August, with assets about 12 per cent less than liabilities.
This is not a matter that companies can ignore, as rating agencies treat their deficits as though they were debt. Companies with big pension shortfalls will show up as looking very indebted, and their credit will be graded accordingly.
How to deal with this? In Europe, the popular approach has been “liability- driven investing”, which in practice means taking as a benchmark the projected cost of liabilities, rather than any measure of the stock market. In practice, this tends to mean that pension funds need to buy more bonds, even at very low rates, to be confident that they can meet their future obligations to pensioners. This in turn raises claims that governments introducing requirements to this effect are practising “financial repression” by forcing pension funds to lend to them at low rates.
In the US, there is also interest in “de-risking”. Beyond liability matching, funds are also offering lump sum buyouts to their pensioners as a way to draw a line under the problem, or buying annuities from insurers and effectively transferring the risk to them. Some 80 per cent of US defined benefit plans are taking some of these measures.
They are also changing what they invest in. Lower bond yields have meant a hunt for higher interest elsewhere. This, by both financial theory and common sense, means taking greater risk.
Hedge fund assets have surged since the crisis, despite performance that looks pathetic compared to what could have been achieved just by tracking an equity index, in large part because their strategies offer the possibility of improving on the returns available on fixed-income bonds.
The problem is not restricted to defined benefit plans. In defined contribution plans, where companies merely guarantee contributions, and the risk of underperformance is taken by the retirees, the issue is the same — only it is small savers who have to deal with it.
Traditionally, the practice has been to invest primarily in equities (which perform best in the long term), and switch steadily towards bonds as retirement approaches. This is known in the jargon as the “glide path” towards retirement. At retirement, savers buy an annuity, based on bonds, that guarantees them an income for life. Many pension plans are now based around “target date” funds that shift their asset allocation based on the expected retirement date.
With rates so low, however, the income from an annuity grows less attractive. The question is whether the glide path should be altered, with investors holding on to a large weighting in stocks long after they retire, and whether new assets should enter the equation.
The notion of buying an annuity has also come into question, leading to the radical reform in the UK that pensioners will no longer be required to buy one. This gives them more freedom but also raises the risks that the unwary will either spend their money too quickly or be persuaded to buy inappropriate investments.
These are all deep dilemmas, which affect everyone’s chances of enjoying a comfortable retirement. And those dilemmas would be made much easier if rates were to rise.